Why The Inflation Target Should Be 0%

A musing that I, at least, find amusing.

So what’s the argument in favour of an inflation target of 2%? Rather than, say, of 0%?

It’s something called “the zero lower bound”. We have two basic macroeconomic levers, fiscal policy - taxes and spending - and monetary - the quantity and price of money.

The basic Keynesian layout - no, not the modern version, the basic - is that we should manage that macroeconomy with monetary policy. Make sure we’ve not got too much inflation, we’re getting some growth, all that stuff, the basic control should be through interest rates and other monetary policy tools. Only when that runs out should we be playing with fiscal policy. Taxes and spending should, in normal times, be done because there’s some problem we want to solve - reduce poverty, pay for the Navy - not because we’re doing macroeconomic management. Leave that to interest rates etc.

OK, but what if the inflation rate falls into deflation? Say and imagine. At that point the “correct” interst rate is negative, below that zero lower bound. Which means we’ve now got to use fiscal policy as we’ve run out of monetary policy that can be used. Fiscal policy always comes with political problems the largest of which being that any increase in spending - note, for these macroeconomic reasons - will be assumed to be baseline spending after the problem is over. We saw that in that claim of 14 years of “Tory austerity”. By 2023 or whatever spending was wildly above that of 2008 but everyone still insisted there had been cuts. Because, of course, spending boomed horrendously in 2009/10.

So, make the inflation target 2%, in anything other than once a generation disasters that will keep the appropriate interest rate above that dread zero lower bound and we’re cool.

Except now the musing. We’ve also tested out that the zero bound - there is no further monetary policy possible when interest rates are at zero - is not, in fact true. We can indeed have more monetary policy. We’ve done it too, quantitative easing.

So, and therefore, as the zero interst rate bound is not, in fact, binding we do not need to have a 2% inflation rate target to avoid hitting it. We can, instead, plan upon proper price stability as we still have monetary tools available.

Now, me, I think near all of macroeconomic management is between silly and planners getting all excited about societal management. Get the basics of microeconomics right and near everything else will be fine naturally. But even given my slight weirdness on the subject I will think this musing works.

We’ve tried QE, now know that we have monetary policy that works at and below the zero lower bound for interest rates. Therefore we don’t need a 2% inflation rate target and we can go for price stability - 0%.